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Scope of Foreign Trust Provisions in the HIRE Act

The 2010 HIRE Act gives
Treasury more authority and procedures to
collect withholding taxes from foreign
financial institutions. The trend for more
transparency and exchange of tax
information among tax treaty countries is
continuing to erode foreign secrecy
sanctuaries.

Foreign financial
accounts and assets are subject to new
reporting requirements with Treasury, as
well as significant new penalties, for
failure to comply with and/or disclose
them. Most provisions are effective for
tax years beginning after March 18,
2010.

Practitioners will be
compelled to establish best practice
procedures, including continuing education
courses to keep themselves and their staff
focused on these foreign reporting issues.
Proper questioning and response follow-up
procedures with each client will be
necessary.

The year 2010 saw the
swift passage of the Hiring Incentives to Restore
Employment Act1 (the HIRE Act) to
jump-start employment and the U.S. economy with
revenue-raising provisions streamlined as new
“offshore anti-abuse” compliance statute provisions.
This article analyzes the foreign trust provisions
and offers some practical guidance for practitioners
to consider in their development of best practice
procedures.

Foreign transactions continue to
proliferate, especially with an increasingly mobile
society and the growth in global family wealth. The
former safe haven of foreign secrecy laws is slowly
being eroded as tax treaty countries seek more
transparency and exchange of tax information.
Starting in 2001, more transparency resulted from
nearly unilateral government initiatives, such as
the U.S. qualified intermediary (QI) system.2 The HIRE Act makes
this trend more effective for Treasury and raises
the bar for taxpayers and their advisers with
stiffer penalties and information disclosure and
reporting requirements. The HIRE Act was signed into
law on March 18, one day after Congress passed it.
It includes new and amended foreign trust statutory
provisions.

Foreign Account Tax Reporting

Increased Disclosure of Beneficial Owners

The HIRE Act created a new Chapter 4, Taxes to
Enforce Reporting on Certain Foreign Accounts, in
Subtitle A of the Code, Secs. 1471–1474 of which
contain new reporting provisions.3 Essentially, foreign
financial institutions with U.S. account holders
will now have the choice of entering into agreements
with the IRS (similar to QIs) to provide information
about their account holders or becoming subject to a
30% U.S. withholding tax on U.S. source payments to
foreign financial institutions, foreign trusts, and
foreign corporations. Under Sec. 1441, qualified
intermediary program participants must comply with
the new requirements as well. Under new Sec. 1471,
foreign financial institutions will be subject to
the 30% withholding tax on income from U.S.
financial assets (withholdable payment made to
foreign financial institutions) unless they agree to
disclose the (1) identity (name, address, TIN) of
any U.S. person, including the U.S. owner of any
account holder that is a U.S.-owned foreign entity
with an account at the foreign institution (or
affiliate), (2) account number, (3) account balance
or value, and (4) gross receipts and gross
withdrawals or payments from the account.4 New Sec. 1471 further
authorizes Treasury to establish verification and
due diligence procedures with each foreign
institution.

Alternatively, the foreign
financial institution can elect to report as if it
were a U.S. person under Sec. 6041 (information at
source), Sec. 6042 (returns regarding payments of
dividends and corporate earnings and profits), Sec.
6045 (returns of brokers), and Sec. 6049 (returns
regarding payments of interest). This election would
require the foreign financial institution to report
on each account holder that is a specified U.S.
person or U.S.-owned foreign entity as if the holder
were a natural person and citizen of the United States.5 A foreign financial
institution that meets the reporting requirements of
Sec. 1471(b) can elect (under Sec. 1471(b)(3)) to
have withholding apply to any withholdable payments
made to the institution to the extent that payments
are allocable to accounts of recalcitrant account
holders. Recalcitrant account holders are those who
do not provide the information required or a waiver
of a foreign secrecy law needed for the institution
to meet the Sec. 1471 reporting requirements. The
taxes withheld would be allocated to the
recalcitrant account holder’s account
balance(s).

The act defines a foreign financial
institution as a foreign entity that (1) accepts
deposits in the ordinary course of a banking or
similar business, (2) is engaged (as a substantial
portion of its business) in holding financial assets
for the account of others, or (3) is engaged (or
holding itself out as being engaged) primarily in
the business of investing, reinvesting, or trading
in securities, partnership interests, commodities,
or any interest in such securities, partnership
interests, or commodities.6 A payment subject to
withholding is defined as any U.S.-source payment of
interest (including any original issue discount),
dividends, rents, salaries, wages, premiums,
annuities, compensation, remuneration, emoluments,
and other fixed or determinable annual or periodical
gains, profits, and income.7

Nonfinancial
institutions, or foreign entities that are not
financial institutions, will be exempt from the 30%
withholding tax if the payee or beneficial owner of
the payment provides the withholding agent with
either (1) proper certification that the beneficial
owner does not have a substantial U.S. owner or (2)
the name, address, and TIN of each U.S. substantial owner.8 The withholding agent
must not know (or have reason to know) that the
certification or information provided regarding the
substantial U.S. owner(s) is incorrect, and the
agent reports the name, address, and TIN of each
substantial owner to the IRS.9 These new Chapter 4
provisions are generally effective for payments
after December 31, 2012.

Reporting on Owners of Foreign Trusts

The HIRE Act defines “substantial owner” of a
foreign trust as a grantor or holder, directly or
indirectly, of more than 10% of the beneficial
interest of such trust.10 The statute
authorizes Treasury to issue new regulations to
coordinate the tax withholding with other
withholding provisions (i.e., Sec. 1441).11

Practice tip: Practitioners should, in
the interest of their foreign trustee clients,
monitor tax withholding (such as on Form 1042,
Annual Withholding Tax Return for U.S. Source Income
of Foreign Persons) by advising that Form W-8BEN,
Certificate of Foreign Status of Beneficial Owner
for United States Tax Withholding, be completed
satisfactorily with each payer to enable the trust
entity to enjoy a reduced U.S. tax treaty
withholding rate, if applicable, instead of the
higher 30% rate.

Foreign Financial Asset
Reporting

New Sec. 6038D imposes new reporting
requirements on individuals who hold more than
$50,000 in (1) any financial account maintained by a
foreign financial institution or (2) any foreign
stock, interest in a foreign entity (including a
foreign trust), or financial instrument with a
foreign counterpart that is not held in a custodial
account of a financial institution. The penalty for
failure to disclose such information, if applicable,
would be $10,000 with increases up to a total
maximum penalty of $50,000 if failure continues
after notification.12

The new
statutory language that imposes the foreign asset
self-reporting requirements does not include the
language “during any part of the tax year” in
reference to the “aggregate value of the account(s)
exceed $50,000” threshold. Presumably, this means
that if at any time the threshold amount is exceeded
during the year, the requirements apply. IRS
Commissioner Douglas Shulman, in prepared remarks,
said, “This [new Sec. 6038D reporting requirement]
is in addition to existing law that requires the
filing of a so-called FBAR form.”13

Practice tip: The commissioner said
taxpayers will report foreign assets worth $50,000
or more on their tax returns. This may require the
creation of a new tax form for the 2010 tax year for
such reporting (with possible cross-referencing to
Form TD F 90-22.1, Report of Foreign Bank and
Financial Accounts (FBAR)).

With respect to
penalties for tax underpayments attributable to
undisclosed foreign financial assets, the HIRE Act
modifies Sec. 6662 by imposing a penalty of 40% of
the amount of any underpayment attributable to an
undisclosed foreign financial asset, which is
defined as any asset for which information must be
provided under Secs. 6038 (information reporting on
certain foreign corporations or partnerships), 6038B
(certain transfers to foreign persons, including
trustees), 6038D (newly enacted, for information on
foreign financial assets), 6046A (returns as to
interests in foreign partnerships), or 6048
(information on certain foreign trusts).14

Expanded
Statute of Limitation Period

The HIRE Act
modifies the general three-year statute of
limitation prescribed under Sec. 6501(e) to extend
it to a six-year statute of limitation if the
taxpayer’s gross income omits an amount in excess of
25% of the gross income that is otherwise properly
includible, or for omissions of more than $5,000 of
income that are attributable to one or more
reportable foreign assets (including any applicable
foreign trust reporting).15

For returns
filed after March 18, 2010, and for any other return
for which the Sec. 6501 assessment period has not
yet expired as of that date, the HIRE Act provides
that the limitation period for assessment is
suspended if a taxpayer fails to provide timely
information returns as required with regard to: (1)
a passive foreign investment company (PFIC) under
Sec. 1295(b) (election by a PFIC shareholder to have
the PFIC treated as a qualified electing fund) or
under Sec. 1298(f), as amended by the act (requiring
a U.S. person that is a PFIC shareholder to file an
annual report), or (2) the new self-reporting of
foreign financial assets information under Sec. 6038D.16 The HIRE Act
modifies the Sec. 6501(c)(8) assessment limitation
period suspension rule generally to provide that for
any information required to be reported under these
provisions, the statute of limitation for any “tax
return, event, or period” to which that information
relates will not expire before the date that is
three years after the date the required information
is furnished to the IRS. However, Section 218(a) of
the so-called Education Jobs Act17 added Sec.
6501(c)(8)(B), which states that in cases where the
failure to furnish the required information is due
to reasonable cause and not willful neglect, the
suspension of the limitation period applies only to
the items related to the failure to provide the
required information.

Practice tip:The HIRE Act omits a
requirement included in an earlier version of FATCA18 that would have
required advisers to disclose certain information to
Treasury. Specifically, the language in the earlier
version provided that tax advisers who derive gross
income in excess of $100,000 for providing service
in acquiring or forming a foreign entity (including
foreign trusts) would be required to file an
information return with Treasury, with penalties for
failure to comply with those procedures.
Practitioners who were previously concerned with
this potential reporting of their services to
Treasury should be pleased with the final language
as enacted.

Practice tip:The possible
repercussions of the expanded statute of limitation
provisions provide additional exposure for
practitioners. Thus, it is in their best interest to
develop “best practice” procedures to determine
which clients have not filed the proper information
returns in the past and ensure that future returns
are timely and accurately filed. Such procedures
could include informing all clients of the new Sec.
6038D requirements and reviewing with them the new
form that will be created for such reporting for the
2010 tax year.

Treatment of Foreign Trusts
with U.S. Beneficiaries

Under prior law, a
U.S. person was treated as the owner of the property
transferred to a foreign trust if the trust had a
U.S. beneficiary. Under the HIRE Act, a foreign
trust is treated as having a U.S. beneficiary if any
current, future, or contingent beneficiary of the
trust is a U.S. person. The act stipulates that a
foreign trust would be treated as having a U.S.
beneficiary if (1) the trustee has discretion to
determine the trust’s beneficiaries, unless the
terms of the trust specifically identify the class
of beneficiaries and none of them are U.S. persons,
or (2) any written, oral, or other agreement could
result in a beneficiary of the trust being or
becoming a U.S. person (such an agreement or
understanding would be treated as terms of the trust instrument).19 Any U.S. person who
directly or indirectly transfers property to a
foreign trust will be presumed to have a U.S.
beneficiary unless that person can show that certain
reporting requirements have been satisfied.20 See the specific
reporting requirements discussed below under
“Presumption That a Foreign Trust Has a U.S.
Beneficiary.”

Observation:Based on statutory history
and interpretations by regulations and other
guidance, an inference that income will be treated
as accumulated for a contingent beneficiary interest
appears to be far-reaching and somewhat vague. At a
time when momentum is gaining for tax reform
simplification, such language deserves
reconsideration and modification. The following
analysis of current statutory provisions and IRS
interpretations will demonstrate the extent and
boundaries of reporting contingent trust beneficiary
interests under U.S. tax laws.

Taxpayers and
their professional advisers have been accustomed to
the IRS guidance and interpretation of Sec. 679(c)
in Regs. Sec. 1.679-2, as finalized by T.D. 8955.
For purposes of the determination of whether a
foreign trust will be treated as having a U.S.
beneficiary under Sec. 679, the regulation provides
that income or corpus may be paid or accumulated to
or for the benefit of a U.S. person during a tax
year of the U.S. transferor if during that year,
directly or indirectly:

Income may be
distributed to, or accumulated for the benefit of,
a U.S. person; or

Corpus may be
distributed to, or held for the future benefit of,
a U.S. person.

This determination is
made without regard to whether income or corpus is
actually distributed to a U.S. person during the
year and without regard to whether a U.S. person’s
interest in the trust income or corpus is contingent
on a future event.21

As such,
these regulations employ a broad approach in
determining whether a foreign trust is treated as
having a U.S. beneficiary. They further recognize
that it may be possible for a U.S. person to obtain
a future benefit from a foreign trust under certain
unexpected circumstances and that the possibility of
these circumstances does not necessarily cause the
foreign trust to be treated as having a U.S.
beneficiary. The regulations provide a narrow
exception to the general determination of whether a
U.S. person can obtain such a benefit:

A person who is not
named as a beneficiary and is not a member of a
class of beneficiaries as defined under the trust
instrument is not taken into consideration if the
U.S. transferor demonstrates to the IRS’s
satisfaction that the person’s “contingent interest”
in the trust is so remote as to be negligible.22

The regulations
further provide that for purposes of the exception
for certain unexpected beneficiaries, a class of
beneficiaries generally does not include heirs who
will benefit from the trust under the laws of
intestate succession in the event that the named
beneficiaries (or members of the named class) have
all died (whether or not stated as a named class in
the instrument).23

Also
significant are other Code section definitions and
treatment of a “constructive ownership interest.”
Sec. 318(a)(3)(B)(i) stipulates that a “contingent
interest of a beneficiary in a trust shall be
considered remote if, under the maximum exercise of
discretion by the trustee in favor of [a particular]
beneficiary, the value of such interest, computed
actuarially, is 5 percent or less of the value of
the trust property.” The corresponding regulation,
Regs. Sec. 1.318-2(c), Example (2), illustrates and
demonstrates the distinction with a vested remainder
interest. The act’s language amending Sec. 679(c)
will necessitate additional time and effort by the
trustee and professional advisers, unless subsequent
regulations stipulate a de minimis value in
some possible cases that could be disregarded with
statutory authority (i.e., the value of which is so
small as to make accounting for it unreasonable or
administratively impractical).

Further, the
legal effects of local law distinctions bearing on
the validity of contingent beneficiary interests’
later becoming vested remainder trust interests
should be considered in the proposed regulations for
amended Sec. 679(c). Such local law authority would
constitute the jurisdictional authority for the
trust and its class of beneficiary designations for
court supervision purposes. It is noteworthy that
the amended statute kept intact Sec. 679(c)(1),
which includes an exception, as provided in newly
designated paragraph (3) of Sec. 679(c), stipulating
that a “U.S. beneficiary is disregarded if such
beneficiary first became a U.S. person more than
five years after the date of such transfer [to the
foreign trust].”

Presumption That a Foreign
Trust Has a U.S. Beneficiary

The HIRE Act
further amended Sec. 679 by redesignating subsection
(d) as subsection (e) and providing in new
subsection (d) that if a U.S. person directly or
indirectly transfers property to a foreign trust,
that trust may be treated as having a U.S. beneficiary.24 However, this new
subsection will not apply if that person can
demonstrate to the satisfaction of Treasury that
under the terms of the trust instrument, no part of
the trust income or corpus may be paid or
accumulated during the year to or for the benefit of
a U.S. person or, if the trust is terminated during
the year, no part of the trust assets could be paid
to or for the benefit of a U.S. person, and that
person provides additional information, as requested
by Treasury, regarding the transfer to the trust.25

Uncompensated Use of Trust Property

The
HIRE Act provides that treatment as a taxable
distribution applies in the year that the trustee of
a foreign trust permits the use of any trust
property directly or indirectly by the U.S. grantor,
U.S. beneficiary, or any U.S. person related to a
U.S. grantor or U.S. beneficiary. If such an event
occurs, the fair market value of the use of the
property is treated as a taxable distribution to the
U.S. grantor or U.S. beneficiary.26 A later return of
the property (to the trustee) treated as a
distribution is disregarded for tax purposes.27 This statutory
provision does not apply to the extent that the
trust (trustee) is paid the fair market value of the
use of the property within a reasonable period of
time after the (personal) use.28

Because any
uncompensated use of trust property is treated as a
taxable distribution from a foreign trust, the user
(i.e., the U.S. beneficiary or U.S. grantor) would
be required to report the use of the property as a
distribution from a foreign trust under Sec. 6048(b)
by filing Form 3520, Annual Return to Report
Transactions with Foreign Trusts and Receipt of
Certain Foreign Gifts. Failure to do so in a timely
and accurate filing would expose such person(s) to
civil penalties up to 35% of the distributed
amount(s).

Observation: Neither the statute nor
the committee reports say what period of time is
considered a reasonable period of time after the
use. Guidance on this issue will likely come when
the IRS issues regulations.

A loan of cash or
marketable securities (or the use of any other trust
property) by a foreign trust directly or indirectly
to or by any U.S. person will cause the trust to be
treated as having a U.S. beneficiary under Sec. 679.29 As a result, the
trust will be treated as a grantor trust for tax
purposes.

Practice tip: The issue of personal use
of trust property by a grantor, trustee, or
beneficiary has legal and ethical overtones, as well
as tax issues to analyze. A primary fiduciary duty
is to administer the trust solely in the interest of
all the trust beneficiaries, including not engaging
in any act that puts personal interests in conflict
with those of any of the trust beneficiaries. A
common type of such conflict of interest is
“self-dealing” by the trustee, which includes any
means by which the trustee uses or allows others to
use trust property for personal use or profit.

The newly enacted Sec. 643(i)(1) expands the
professional exposure of practitioners related to
the proper disclosure and reporting on these issues.
Best practice procedures might include seeking
advice from counsel if practitioners suspect such
activities in a trust engagement. Another procedure
might include advising the trustee to keep daily
logs on the use of trust property (real and personal
property) by third parties, beneficiaries, or the
trustee. Use by any beneficiary or trustee should be
documented by recordkeeping procedures to
substantiate the appropriate reporting, as well as
any payment(s) received by the foreign trust for
such use, if personal in nature. Practitioners might
also advise trustees that the daily logs should
indicate performance of minor maintenance procedures
on trust property by third parties, beneficiaries,
and trustees. Advice to the trustee could include
obtaining written opinions from qualified appraisers
as to whether the value of the trust property is
being maintained or enhanced by such maintenance.
This will help the trustee defend against possible
audit issues involving measurement of any economic
benefit to the property without payment of
compensation.

With regard to the trust assets,
beneficiaries have been known to assist the trustee
in maintaining and safeguarding the condition of
certain trust assets, without compensation from the
trustee. For example, beneficiaries will sometimes
do lawn and landscape maintenance on real property
or wash vehicles owned by the trust without
requesting monetary compensation from the trustee.
In many such cases, the beneficiary feels that he or
she is preserving the value of the particular asset,
which may be property rented to third parties by the
trustee and later sold to a third party or
distributed to the beneficiary (as a property
distribution). In such cases the beneficiary is not
using the applicable asset for personal use but is
instead preserving its value for future disposition
by the trustee.

Some practitioners might
question Treasury’s ability to audit personal use of
trust property, especially when it may be located
overseas. However, documentation of use, whether
personal, maintenance, repair, or rental to a third
party at fair rent, puts the trustee in a more
defensible position to answer a challenge if an IRS
auditor raises such an issue (i.e., to prove that
the issue of a taxable distribution should not be
made).

When Treasury issues the proposed
regulation on amended Sec. 643(i), it would be
helpful for it to include a provision for de
minimis amounts for which values are so small as
to make accounting for them unreasonable or
administratively impractical. It should also
consider a provision for an inflation adjustment to
increase the de minimis amount by incremental
amounts in the future. Such modifications would
prevent de minimis amounts from being treated
as contributions to or distributions from a foreign
trust.

Minimum Penalty on Reporting
Requirement for U.S. Owners of Foreign Trusts

The 2010 HIRE Act imposes a minimum penalty of
$10,000 on any failure to file an information return
(as required under Sec. 6048) for certain
transactions involving foreign trusts (e.g., the
creation of a foreign trust, the transfer of money
or property to a foreign trust, or the death of a
U.S. owner of a foreign trust).30 Thus, the penalty is
the greater of $10,000 or 35% of the gross value of
the reportable amount of such failure to report.

In the case of the requirement for a U.S. person
treated as a grantor of a foreign trust to report
the trust activities, a failure to properly report
results in the penalties described above, as well
asthe initial civil penalty of 5% of the
gross reportable amount, as stipulated in Sec.
6048(b). Notwithstanding this minimum penalty, the
gross amount of penalties that can be assessed
cannot exceed the amount required to be disclosed on
such return(s).31

Practice tip:The penalties are payable
on notice and demand and can be assessed and
collected in the same manner as tax assessments.
However, the deficiency procedures that apply to
income, estate, gift, and certain excise taxes do
not apply for the assessment or collection of these penalties.32 Because these
potential penalties impose such a great exposure for
tax practitioners, the importance of using best
practice procedures, including checklists and client
interview questionnaires, cannot be overlooked.
Unfortunately, Notice 97-3433 continues to be the
primary guidance from Treasury on the enforcement of
Sec. 6677.

Practice tip:The IRS issued interim
guidance on December 7, 2009, for making a
“determination” of penalties assessed under Sec. 6677.34 The memorandum
introduced “four redesigned letters” to be used by
IRS officials in the determination process
procedures. The form letters incorporate each
taxpayer’s facts and data and summarize the reasons
and amounts of specific penalty assessments based
upon the individual taxpayer’s facts and
circumstances. However, because of the lack of
formal IRS regulations, guidance has not been
provided yet as to how this evaluation process will
be conducted and when and how “reasonable cause”
issues can affect or assist in the determination
process.

Tips on Guidelines and
Procedures

The FATCA provisions of the HIRE
Act have hastened the U.S. development of tax
compliance on a global scale. There has been rapid
progress in recent years toward establishing common
international standards for tax transparency. The
Group of Twenty has provided strong political
impetus, although the Organisation of Economic
Co-operation and Development (OECD) has done most of
the practical work. The result has been a rapidly
growing framework of agreements and treaties between
countries to exchange information and cooperate on
tax administration. Tax administrators from over 40
countries reaffirmed their commitment to offshore
tax compliance and endorsed the use of joint audits
at the sixth meeting of the OECD’s Forum on Tax
Administration (FTA), held on September 15 and 16,
2010, in Istanbul. The FTA, chaired by IRS
commissioner Shulman, issued a communiqué that
outlined its strategies to improve compliance and
taxpayer services. It indicated that major
improvements in compliance could be obtained through
“joint audits,” where two or more countries would
join to form a single audit team to conduct a
taxpayer tax examination.35

All tax
practitioners are exposed to the severity and scope
of the new HIRE Act provisions as analyzed above,
regardless of whether they provide international tax
services. As long as the U.S. tax regime continues
to tax U.S. taxpayers on worldwide income,
practitioners will face these “foreign account or
foreign trust” reporting issues with their clients.
Professional relationships between clients and
practitioners face increasing stress and scrutiny.
What is not said or not disclosed will continue to
expose practitioners to multiple perils for many
years after the events. Maintaining adequate
continuing education for all owners and staff is
paramount. Maintaining quality control policies and
procedures that ensure tax compliance is imperative.
It now becomes more important for each practitioner
and firm to decide how to handle these delicate
issues with each and every client and to adequately
document the clients’ responses.

Footnotes

1 Hiring Incentives to
Restore Employment Act, P.L. 111-147.

2 This system forces
non-U.S. banks to become QIs to assist the IRS with
U.S. tax withholding responsibility under Sec.
1441.

3 New Secs. 1471–1474
are also referred to as FATCA because they were
originally in the Foreign Account Tax Compliance Act
of 2009.

4 Sec. 1471(c)(1).

5 Sec. 1471(c)(2).

6 Sec. 1471(d)(5).

7 Sec. 1473(1).

8 Secs. 1472(a) and
(b).

9 Sec. 1472(b)(2).

10 Sec.
1473(2)(A)(iii).

11 Secs. 1474(d) and
(f).

12 Sec. 6038D(d).

13 IR 2010-68
(5/27/10).

14 Sec. 6662(j), as
added, effective for tax years beginning after March
18, 2010.

15 Sec.
6501(e)(1)(A), as amended by the HIRE Act.

16 Sec. 6501(c)(8),
as amended by HIRE Act §513(b).

17 P.L. 111-226,
enacted August 10, 2010, without a title, but
commonly referred to as the Education Jobs Act.

Lawrence McNamara is a
sole practitioner in Bend, OR. He is a member of the
AICPA’s Trust, Estate and Gift Tax Technical
Resource Panel, its Foreign Trust Task Force, and
its Trust Accounting Income Task Force–Technical
Issues Working Group. For more information about
this article, contact Mr. McNamara at larry@lhmcpa.com.

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